Volatility Contraction Pattern
JS-Masterclass #4: The Volatility Contraction Pattern
The Volatility Contraction Pattern (VCP) is a vital concept for successful traders and a key element in our JS-TechTrading strategy. In this tutorial, we will cover the following:
1. Why is it important?
2. The ‘Overhead Supply’ Concept
3. How to identify a VCP?
4. The Perfect Entry Point
1. Why is it important?
The Volatility Contraction Pattern (VCP) allows us to find stocks which are getting ready to form a very specific low risk entry point at which the potential reward of our trades outweigh the risk.
The main role that VCP plays is establishing a precise entry point at the line of least resistance.
If a stock is under accumulation (large institutions putting their money into the stock), a price consolidation represents a period when strong investors ultimately absorb weak traders. Once the “weak hands” have been eliminated, the lack of ‘overhead supply’ (explanation see below) allows the stock to quickly move higher because even a small amount of demand will overwhelm the negligible inventory. This is referred to as the line of least resistance. Tightness in price from absolute highs to lows and tight closes with little change in price from one day to the next and also from one week to the next can generally found in constructive Volatility Contraction Patterns. These tight areas should be accompanied by a significant decrease in trading volume.
2. The ‘Overhead Supply’ Concept
Any price action in the stock market is the simple result of supply and demand, just like in any other business. If demand is bigger than the supply, the price goes up. If supply outweighs demand, prices are falling, it is as simple as that!
What happens to supply and demand in a Volatility Contraction Pattern?
Point 1: Traders buying at point 1 in the graphic are called ‘Trapped Buyers (TBs)’.
Point 2: the price has fallen and many people think the stock is ‘cheap’ at this price and buy the stock – the so called ‘Bottom Fishers (BFs)’ provide the relevant demand needed to trigger a price increase.
Point 3: the price has come back up to the level at point 1. Now two things happen
a) The Trapped Buyers who bought a price level 1 are very happy to get out of the trade at breakeven after having had paper losses at point 2. The cut their losses (LC) and provide the relevant supply to the market needed to trigger a declining price.
b) The Bottom Fishers take nice quick profits and sell their stocks, providing additional supply to the market which adds to the decline in price.
Points 4, 5, 6: The same concept applies here but as time goes by, the volatility contracts from left to right as fewer and fewer traders provide their demand and supply to the market, the price action dries out like a towel:
3. How to identify a VCP?
A common characteristic of virtually all constructive price structures (those under accumulation) is a contraction of volatility, from greater volatility on the left side of the price base to lesser volatility on the right side in the chart. This pattern needs to be accompanied by specific areas in the base structure where volume contracts significantly:
Let’s look at an example:
In this example, we are seeing a total of 5 contractions from left to right, starting from 1 (ca. 25% decline) to 5 (< 5% decline) under significantly reduced trading volume. This is exactly what we want to see. At the final base 5, supply has stopped coming to market which is the reason for the low trading volume in this time-period.
Due to the lack of supply, only very few demand is needed to push the price significantly higher. We therefore have a high probability of an explosive price increase. Also, we can set our SL just below the final base at 5 which means that our max. risk for this trade is < 5% - our potential reward significantly outweighs our risk.
4. The Perfect Entry Point
When the price breaks out of the right side of the final base under higher volume, we have a perfect entry point. As the supply has stopped coming to market, only little demand is needed to cause an explosive price move upwards. Furthermore, the volatility contraction results in a tight base at the right end of the pattern resulting in a low risk entry point – the Stop-Loss can be set under the low of the latest base structure on the right side of the pattern which is normally in the range of about 5% risk. This is a vital concept for successfully timing the continuation of an existing trend.
The Volatility Contraction Pattern (VCP) is a vital concept for successful traders and a key element in our JS-TechTrading strategy. In this tutorial, we will cover the following:
1. Why is it important?
2. The ‘Overhead Supply’ Concept
3. How to identify a VCP?
4. The Perfect Entry Point
1. Why is it important?
The Volatility Contraction Pattern (VCP) allows us to find stocks which are getting ready to form a very specific low risk entry point at which the potential reward of our trades outweigh the risk.
The main role that VCP plays is establishing a precise entry point at the line of least resistance.
If a stock is under accumulation (large institutions putting their money into the stock), a price consolidation represents a period when strong investors ultimately absorb weak traders. Once the “weak hands” have been eliminated, the lack of ‘overhead supply’ (explanation see below) allows the stock to quickly move higher because even a small amount of demand will overwhelm the negligible inventory. This is referred to as the line of least resistance. Tightness in price from absolute highs to lows and tight closes with little change in price from one day to the next and also from one week to the next can generally found in constructive Volatility Contraction Patterns. These tight areas should be accompanied by a significant decrease in trading volume.
2. The ‘Overhead Supply’ Concept
Any price action in the stock market is the simple result of supply and demand, just like in any other business. If demand is bigger than the supply, the price goes up. If supply outweighs demand, prices are falling, it is as simple as that!
What happens to supply and demand in a Volatility Contraction Pattern?
Point 1: Traders buying at point 1 in the graphic are called ‘Trapped Buyers (TBs)’.
Point 2: the price has fallen and many people think the stock is ‘cheap’ at this price and buy the stock – the so called ‘Bottom Fishers (BFs)’ provide the relevant demand needed to trigger a price increase.
Point 3: the price has come back up to the level at point 1. Now two things happen
a) The Trapped Buyers who bought a price level 1 are very happy to get out of the trade at breakeven after having had paper losses at point 2. The cut their losses (LC) and provide the relevant supply to the market needed to trigger a declining price.
b) The Bottom Fishers take nice quick profits and sell their stocks, providing additional supply to the market which adds to the decline in price.
Points 4, 5, 6: The same concept applies here but as time goes by, the volatility contracts from left to right as fewer and fewer traders provide their demand and supply to the market, the price action dries out like a towel:
3. How to identify a VCP?
A common characteristic of virtually all constructive price structures (those under accumulation) is a contraction of volatility, from greater volatility on the left side of the price base to lesser volatility on the right side in the chart. This pattern needs to be accompanied by specific areas in the base structure where volume contracts significantly:
Let’s look at an example:
In this example, we are seeing a total of 5 contractions from left to right, starting from 1 (ca. 25% decline) to 5 (< 5% decline) under significantly reduced trading volume. This is exactly what we want to see. At the final base 5, supply has stopped coming to market which is the reason for the low trading volume in this time-period.
Due to the lack of supply, only very few demand is needed to push the price significantly higher. We therefore have a high probability of an explosive price increase. Also, we can set our SL just below the final base at 5 which means that our max. risk for this trade is < 5% - our potential reward significantly outweighs our risk.
4. The Perfect Entry Point
When the price breaks out of the right side of the final base under higher volume, we have a perfect entry point. As the supply has stopped coming to market, only little demand is needed to cause an explosive price move upwards. Furthermore, the volatility contraction results in a tight base at the right end of the pattern resulting in a low risk entry point – the Stop-Loss can be set under the low of the latest base structure on the right side of the pattern which is normally in the range of about 5% risk. This is a vital concept for successfully timing the continuation of an existing trend.
Combing the BEST of two WORLD's: Cathie Wood & Mark Minervini
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